Monetary Policy Summary

The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment. At its meeting ending on 1 February 2023, the MPC voted by a majority of 7–2 to increase Bank Rate by 0.5 percentage points, to 4%. Two members preferred to maintain Bank Rate at 3.5%.

Global consumer price inflation remains high, although it is likely to have peaked across many advanced economies, including in the United Kingdom. Wholesale gas prices have fallen recently and global supply chain disruption appears to have eased amid a slowing in global demand. Many central banks have continued to tighten monetary policy, although market pricing indicates reductions in policy rates further ahead.

UK domestic inflationary pressures have been firmer than expected. Both private sector regular pay growth and services CPI inflation have been notably higher than forecast in the November Monetary Policy Report. The labour market remains tight by historical standards, although it has started to loosen and some survey indicators of wage growth have eased, alongside a gradual decline in underlying output. Given the lags in monetary policy transmission, the increases in Bank Rate since December 2021 are expected to have an increasing impact on the economy in the coming quarters.

Near-term data developments will be crucial in assessing how quickly and to what extent external and domestic inflationary pressures will abate. As set out in the accompanying February Monetary Policy Report, the MPC’s updated projections show CPI inflation falling back sharply from its current very elevated level, of 10.5% in December, in large part owing to past increases in energy and other goods prices falling out of the calculation of the annual rate. Annual CPI inflation is expected to fall to around 4% towards the end of this year, alongside a much shallower projected decline in output than in the November Report forecast.

In the latest modal forecast, conditioned on a market-implied path for Bank Rate that rises to around 4½% in mid-2023 and falls back to just over 3¼% in three years’ time, an increasing degree of economic slack, alongside falling external pressures, leads CPI inflation to decline to below the 2% target in the medium term. There are considerable uncertainties around this medium-term outlook, and the Committee continues to judge that the risks to inflation are skewed significantly to the upside.

The MPC’s remit is clear that the inflation target applies at all times, reflecting the primacy of price stability in the UK monetary policy framework. The framework recognises that there will be occasions when inflation will depart from the target as a result of shocks and disturbances. The economy has been subject to a sequence of very large and overlapping shocks. Monetary policy will ensure that, as the adjustment to these shocks continues, CPI inflation will return to the 2% target sustainably in the medium term. Monetary policy is also acting to ensure that longer-term inflation expectations are anchored at the 2% target.

The Committee has voted to increase Bank Rate by 0.5 percentage points, to 4%, at this meeting. Headline CPI inflation has begun to edge back and is likely to fall sharply over the rest of the year as a result of past movements in energy and other goods prices. However, the labour market remains tight and domestic price and wage pressures have been stronger than expected, suggesting risks of greater persistence in underlying inflation.

The extent to which domestic inflationary pressures ease will depend on the evolution of the economy, including the impact of the significant increases in Bank Rate so far. There are considerable uncertainties around the outlook. The MPC will continue to monitor closely indications of persistent inflationary pressures, including the tightness of labour market conditions and the behaviour of wage growth and services inflation. If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required.

Looking further ahead, the MPC will adjust Bank Rate as necessary to return inflation to the 2% target sustainably in the medium term, in line with its remit.

1: The economic outlook

1.1: The conditioning assumptions underlying the MPC’s projections

As set out in Table 1.B, the MPC’s projections are conditioned on:

• The paths for policy rates implied by financial markets, which have moved lower since November, as captured in the 15-day average of forward interest rates to 24 January (Chart 2.7). In the United Kingdom, the market-implied path for Bank Rate now peaks at around 4½% in 2023 Q3, down from nearly 5¼% at the time of the November Report, and ends the forecast period at just over 3¼%.
• A path for the sterling effective exchange rate index that is nearly 2% stronger on average than in the November Report, and is depreciating gradually over the forecast period given the role for expected interest rate differentials in the Committee’s conditioning assumption.
• Fiscal policy that evolves in line with announced Government policies to date. As explained in detail in Box B, the Government has, since the November Report, set out its fiscal plans in the Autumn Statement and announced further energy support for businesses in January. In the Autumn Statement, the Government confirmed that the Energy Price Guarantee (EPG) for households would be adjusted, such that a household with typical energy use will pay a maximum of £3,000 per year from April 2023 until the end of March 2024. This is an increase in the ceiling from the £2,500 per year previously announced as in place until March 2023.
• Wholesale energy prices that follow their respective futures curves over the whole forecast period, as was the case in the November Report. Although volatile, spot gas and oil prices have declined since November and the gas futures curve has also fallen markedly (Chart 2.3). Under this lower path for wholesale energy prices, it is assumed that the EPG will cease to bind on household energy prices from 2023 Q3 onwards. Instead, prices are assumed to evolve in line with Bank staff estimates of the Ofgem price cap. Significant uncertainty remains around the outlook for wholesale energy prices, and the Committee will keep its wholesale energy price conditioning assumption under review.

Table 1.B: Conditioning assumptions ^{(a) (b)}

1.2: Key judgements and risks

Key judgement 1: the level of potential output is being held back by a series of adverse economic shocks. Supply growth is expected to be weak by historical standards over the forecast period.

Potential supply determines the level of output the economy can sustain without generating excessive inflationary pressures. Since the previous Monetary Policy Report, the Committee has concluded its supply stocktake (Section 3), which has fed into the construction of its latest economic projections.

The economy has been hit by a series of significant economic shocks over recent years: the change in the UK’s trading relationship with the European Union, the Covid pandemic and developments in global energy prices relating to Russia’s invasion of Ukraine. These factors have held back both potential productivity and labour supply, and hence the overall supply capacity of the economy.

The move to a new trading relationship with the EU has been expected to weigh on potential productivity. Around the time that the UK left the EU, the MPC judged that increased barriers to trade could mean that, all else equal, the level of productivity would be around 3¼% lower in the long run given productivity’s empirical relationship with openness (Box 1 of the November 2019 Report). At the time of the MPC’s previous supply stocktake in November 2021, it was expected that a sizeable proportion of this effect would be weighing on productivity by the end of the current forecast period. Although there remains considerable uncertainty about how to interpret the latest data, Bank staff analysis suggests that EU goods trade volumes have fallen by more than previously expected (Section 3.3). As a result, in the MPC’s current forecast, more of the previously estimated effect of EU withdrawal on productivity takes effect by the end of the forecast period than was the case previously.

Business investment has been very subdued for a number of years (Chart 3.7), weighing on potential labour productivity. Capital spending growth stalled after 2016. The economic uncertainty associated with the pandemic, and more recently the global energy price shock, is also likely to have weighed on business investment. More generally, the direct and indirect effects of the pandemic are judged to be weighing a little on the level of potential productivity by the end of the forecast period (Section 3.3).

The unusually large size of the energy price shock, and therefore the scale of adjustment required by businesses, could lead to broader effects on potential productivity beyond the usual indirect effects via, for example, lower investment (Section 3.3). These could occur if large increases in energy prices have led to disruption or to lower utilisation of energy-intensive capital. The MPC judges that some weakness in potential productivity from these channels is likely to be occurring, but the majority of this direct effect of high energy prices on potential supply is expected to dissipate over the remainder of the forecast period.

Labour market inactivity remains materially higher than before the pandemic, with the increase having been much sharper and larger than implied by the long-running demographic trend through an ageing population alone. Many of the people who have left the labour force since the start of the pandemic were aged 50 to 64, suggesting that early retirement could be playing a significant role. Much of the decline in aggregate participation has also been from those stating subsequently they are not active in the labour market owing to long-term sickness. More broadly, there appears to be increasing detachment among those who have left the labour market recently (Section 3.3). Reflecting these factors, the MPC has judged as part of this stocktake that the fall in measured participation has also been reflected in potential participation and hence weaker potential labour supply. The effects of the pandemic on potential participation are assumed to start to fade, but some effect persists beyond the end of the forecast period.

Overall, the Committee judges that this constellation of economic shocks has already weighed on the level of estimated potential supply materially and will continue to weigh on it over the forecast period. In the MPC’s February projections, potential supply growth is expected to average almost 1% per year over 2023–25, just over half of its growth rate in the decade before the pandemic (Table 3.A). That is accounted for by very weak projected potential labour supply growth, including the adverse impact of long-running demographic trends. Average growth in estimated potential productivity over the 2023–25 period is expected to be broadly similar to 2010–19, but below the rate that the economy might otherwise have achieved in the absence of the shocks it is facing.

Relative to the projections at the time of the Committee’s previous stocktake in November 2021, the level of estimated potential supply is expected to be around 4½% weaker by the end of the forecast period. This reflects a number of factors, including: the extent to which weakness in external goods trade and in business investment appear likely to be affecting potential productivity; the MPC’s updated judgement on lower potential labour market participation; and the direct and indirect effects of the energy price shock on supply.

There are risks in both directions around the projection for supply growth.

As supply cannot be observed directly, the Committee’s estimates of potential output and its components, and the relative weights of different economic shocks in explaining supply’s recent and prospective weakness, are inherently uncertain. In particular, it remains very hard to disentangle the effects on potential productivity from the UK leaving the EU, from the pandemic and from the energy price shock. It is also difficult to distinguish the extent to which weakness in labour market activity is persistent or temporary, and the extent to which it may be having an impact on spare capacity in the economy.

There are risks in both directions around the MPC’s projection for supply growth. On the upside, the Committee’s latest forecast is materially weaker than prior to the pandemic and its previous stocktake, and is also notably weaker than other external forecasters including the Office for Budget Responsibility’s latest projections. Although the MPC’s central projection now includes some near-term weakness in potential productivity linked to the direct effect of high energy prices, it remains possible that changes to measured productivity as a result of the energy price shock are purely cyclical responses affecting output but with no underlying effect on potential supply. The outlook for potential labour market participation could also be stronger than the Committee expects. For example, cost of living pressures and reduced wealth for some households may encourage some people, including those that may have retired earlier than they would otherwise have done owing to the pandemic, to return to the labour market.

On the downside, there could be a larger or more persistent direct effect of high energy prices on potential productivity than the Committee now expects. Or it is possible that weakness in potential labour market participation related to the pandemic and long-term sickness persists for longer than the MPC has assumed in its latest central projection, even if cost of living pressures might otherwise encourage these people to re-enter the labour market.

Key judgement 2: high energy prices and the path of market interest rates continue to weigh on GDP, both at home and abroad, and output is expected to fall slightly throughout 2023 and 2024 Q1. This is nevertheless a much shallower decline than in November, in part reflecting the MPC’s reassessment of the outlook for consumption in light of the recent strength of the labour market, as well as the decline in wholesale energy prices.

After falling by 0.3% in 2022 Q3, UK GDP is expected to have grown by 0.1% in Q4. Underlying output, calculated as market sector output adjusted for the estimated effects of additional bank holidays, is expected to have fallen in Q4 albeit by less than in Q3. GDP is then expected to fall by 0.1% in 2023 Q1, consistent with the steer from most business surveys.

The stagnation in GDP around the turn of the year in part reflects the squeeze on real incomes, and hence household and business spending, from past increases in global energy, tradable goods and food prices. The significant fall in wholesale, and prospective household and business, energy prices since the November Report (Section 1.1) reduces the drag on GDP from the real income squeeze. The path of energy prices is still historically high, nevertheless, and continues to put some downward pressure on growth over the first half of the MPC’s forecast period relative to what it would have been in the absence of an energy price shock.

Weakness in GDP also reflects the pass-through of past increases in Bank Rate and the market-implied path underpinning the forecast (Section 1.1). Given the lags in monetary policy, the rise in Bank Rate since December 2021 is expected to have an increasing impact on the economy in coming quarters. The decline in the market path for Bank Rate over recent months nevertheless pushes up on activity relative to the November Report projections. Rates on new mortgages have declined since November but remain materially higher than in mid-2022. Since November, the FTSE All-Share index has risen and sterling corporate bond spreads have declined (Section 2.1).

The MPC’s November forecast incorporated the announcements made by the Chancellor of the Exchequer up to and including 17 October. As set out in Box B, the Autumn Statement announced some additional fiscal support in the near term, including targeted cost of living support in addition to the extended Energy Price Guarantee scheme, cuts in business rates, and increased spending on health, social care and education. From fiscal year 2024–25, planned fiscal policy will tighten by progressively larger amounts, with net tax rises accounting for around half of this tightening and reductions in both departmental current and capital spending accounting for the other half. Overall, Bank staff estimate that these additional policy measures will, relative to what was assumed in the November Report, increase the level of GDP by around 0.3% on average in the first year of the forecast, but reduce the level of GDP by 0.4% on average in the final year of the forecast.

Taking account of all announced government plans, there is some near-term support to GDP growth from fiscal policy, but policy is expected to tighten over the final two years of the MPC’s forecast period.

The weakness in UK demand growth over the projection also reflects a subdued outlook for the global economy, although that outlook is broadly unchanged compared to November. Rising Covid cases have been weighing on activity in China owing to voluntary social distancing, but growth is then expected to recover as disruption eases. In the MPC’s central projection, annual UK-weighted world GDP growth is projected to slow from 3% in 2022, to 1% in 2023, before rising thereafter but to below pre-pandemic rates (Table 1.D).

In addition to these factors affecting GDP growth, the Committee has reassessed its outlook for spending in the economy. In light of the recent strength in the labour market, the Committee judges that the expected weakening in labour demand is more likely than usual to be reflected in a reduction in vacancies than an increase in redundancies. This effect, consistent with some hoarding of labour by companies and lower perceptions of the risk of job losses, is likely to result over time in lower precautionary saving by households than previously assumed. Together, these are projected to lead to stronger consumption and output, and a smaller increase in the unemployment rate (Key judgement 3), than would otherwise be the case.

In the Committee’s central projection, GDP is projected to fall slightly throughout 2023 and 2024 Q1, as high energy prices and the path of market interest rates weigh on output. The path of demand also reflects the weakness of the potential supply projection, including the extent to which that path is accounted for by anticipated weakness in permanent incomes. This forecast is consistent with the technical definition of a recession, which is at least two consecutive quarters of falling output. But this is a much shallower profile for the decline in output than in the equivalent November Report projection and compared with previous UK recessions (Chart 1.2). Calendar-year GDP growth is expected to be –½% in 2023 and –¼% in 2024 (Table 1.D). Four-quarter GDP growth picks up to almost 1% by the end of the projection (Chart 1.1), although growth is expected to remain well below pre-pandemic rates.

As part of a periodic review, Bank staff have updated in this Report the uncertainty parameters determining the widths of the GDP growth, unemployment and CPI inflation fan charts. These parameters have been calibrated to match the historical forecast errors since 2004 for each variable at different horizons, including putting a reduced weight on errors during the pandemic, given its exceptional nature. As a result, the width of the unemployment fan chart has been reduced significantly over much of the forecast period, while the widths of the GDP growth (Chart 1.1) and CPI inflation fan charts are slightly narrower in the near term.

Within the components of GDP, calendar-year household spending is expected to fall by ½% in 2023 but to rise by ½% in 2024 and in 2025 (Table 1.D), a stronger profile than in the November Report owing to the Committee’s reassessment of the feedback between consumption and the strong starting point of the labour market, as well as the recent decline in wholesale energy prices. Real post-tax household disposable income is projected to follow a similar but more amplified pattern, falling by ½% this calendar year despite some boost from fiscal transfers, but rising by 1½% in 2024. The household saving ratio is nevertheless expected to be broadly flat over much of the forecast period, following some volatility around the turn of this year reflecting movements in unobserved pension components of non-labour income related to the period of financial market dysfunction last autumn.

Timely indicators suggest that house prices are likely to have fallen over recent months, after several years of strength. Alongside falling prices, indicators of housing activity such as mortgage approvals have declined sharply. Weakness in the economic outlook, combined with the impact of higher mortgage rates, is also expected to weigh on housing investment. It falls by over 6% this year, having risen by 8½% in 2022. Housing investment is expected to weaken further in 2024, falling by 8½%, before stabilising in 2025 (Table 1.D).

In part reflecting the series of shocks affecting the economy (Key judgement 1) and the extent to which companies are now assumed to hoard labour over the forecast period, business investment is expected to fall by 5½% in 2023 and by a further 5¾% in 2024, before recovering slightly in 2025 (Table 1.D).

In the GDP projection conditioned on the alternative assumption of constant interest rates at 4%, growth is slightly weaker than in the MPC’s forecast conditioned on market rates.

Chart 1.1: GDP growth projection based on market interest rate expectations, other policy measures as announced

Footnotes

• The fan chart depicts the probability of various outcomes for GDP growth. It has been conditioned on Bank Rate following a path implied by market yields, but allows the Committee’s judgement on the risks around the other conditioning assumptions set out in Section 1.1, including wholesale energy prices, to affect the calibration of the fan chart skew. To the left of the shaded area, the distribution reflects uncertainty around revisions to the data over the past. To the right of the shaded area, the distribution reflects uncertainty over the evolution of GDP growth in the future. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that the mature estimate of GDP growth would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns are also expected to lie within each pair of the lighter aqua areas on 30 occasions. In any particular quarter of the forecast period, GDP growth is therefore expected to lie somewhere within the fan on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions GDP growth can fall anywhere outside the aqua area of the fan chart. Over the forecast period, this has been depicted by the grey background. See the Box on page 39 of the November 2007 Inflation Report for a fuller description of the fan chart and what it represents.

Chart 1.2: Changes in GDP since pre-recession peak in past recessions and the MPC's February 2023 projection ^(a)

Footnotes

• Sources: ONS and Bank calculations.
• (a) Recessions are defined as at least two consecutive quarters of negative GDP growth. Past recessions shown began in 1980 Q1, 1990 Q3 and 2008 Q2. The MPC's projections start in 2022 Q4.

The risks around the projection for GDP growth are judged to be balanced.

There are risks in both directions around the central projection for household spending and hence GDP. Spending could be stronger than expected if some households run down their savings to a greater extent than projected, although the Committee’s new judgement to take account more explicitly in its GDP projection of the strong starting point of the labour market may limit the scale of this risk relative to previous projections. Nevertheless, as set out in the Annex of this Report, external forecasters’ medium-term projections for activity remain materially stronger than the MPC’s. Conversely, demand could weaken by more than expected if some people become more worried about their job security and build up their savings to a greater extent. The recent resilience of the labour market could also indicate a change in the standard relationship between employment and GDP, rather than implying a stronger outlook for both as the Committee is now assuming.

More broadly, the MPC’s projections are constructed based on the average relationships over the past between Bank Rate, other financial instruments and economic activity through the monetary transmission mechanism. The Committee will continue to keep these relationships under review, including how they may have changed during the current monetary policy tightening cycle.

Key judgement 3: the UK economy is judged to have been in excess demand over recent quarters. Although supply is expected to remain weak, continued headwinds to demand are projected to lead to an increasing degree of economic slack emerging from 2023 Q2.

A range of indicators suggest there has been a significant margin of excess demand in the economy over recent quarters. In the Committee’s latest projections, that is accounted for primarily by a higher than usual degree of capacity utilisation within companies. As a counterpart to the Committee’s judgement to revise down the path of potential labour market participation (Key judgement 1), however, the level of capacity utilisation is judged to be contributing somewhat less to aggregate excess demand over recent quarters than in the November Report.

Despite signs of a stagnation in employment and an easing in recruitment difficulties, the labour market has remained tight. Although vacancies have fallen, the stock of vacancies has remained high relative to the number of unemployed people. The unemployment rate was 3.7% in the three months to November, below the MPC’s assessment of the long-term equilibrium rate of unemployment, which stands at just above 4%, unchanged following the Committee’s latest stocktake (Section 3.3). The medium-term equilibrium rate of unemployment, which is also affected by cyclical factors such as changes in the mix of jobs and job seekers, and is more relevant for determining wage pressures, is estimated to have been at a similar level to the long-term rate over recent quarters, having previously risen above the long-term rate during the pandemic.

Although supply is expected to remain weak, continued headwinds to demand lead to an increasing degree of economic slack emerging in the Committee’s projections from 2023 Q2. Companies are expected to respond to this weakness by retaining their existing inputs, while using them less intensively and hoarding labour for a prolonged period. Many of the Agents’ contacts report that they are reluctant to actively reduce headcount, and intend to accommodate weaker demand through attrition or by reducing working hours. That is consistent with capacity utilisation within companies falling, to below its usual level, and with average hours worked declining to below its equilibrium level. As a result, other labour market indicators are expected to remain relatively tight in the near term. In the MPC’s central projection, the unemployment rate is projected to rise modestly, to 4.3%, by 2023 Q4.

Unemployment is nevertheless expected to increase over the remainder of the forecast period, with the jobless rate rising to around 5¼% (Chart 1.3). Even though this is accompanied by a rise in the medium-term equilibrium rate of unemployment, owing to the cyclical effects of the prolonged downturn, the increase in the actual unemployment rate leads to a widening degree of spare capacity in the labour market.

Overall, the output gap is expected to widen significantly, to around 2% of potential GDP by the end of the forecast period (Table 1.A), with nearly half of that slack comprised of spare capacity within companies rather than in the labour market. Such a composition of the output gap is unusual relative to previous recessionary periods, but is consistent with the projected downturn being very shallow in comparison.

Both aggregate spare capacity and the unemployment rate increase by less in the Committee’s latest projections than in the November Report. This reflects the lower conditioning paths for energy and market interest rates, but is also accounted for by the MPC’s reassessment of the feedback between consumption and the strong starting point of the labour market (Key judgement 2).

In projections conditioned on the alternative assumption of constant interest rates at 4%, the unemployment rate rises by slightly more in the medium term than in the MPC’s forecast conditional on market rates.

Chart 1.3: Unemployment rate projection based on market interest rate expectations, other policy measures as announced

Footnotes

• The fan chart depicts the probability of various outcomes for LFS unemployment. It has been conditioned on Bank Rate following a path implied by market yields, but allows the Committee’s judgement on the risks around the other conditioning assumptions set out in Section 1.1, including wholesale energy prices, to affect the calibration of the fan chart skew. The coloured bands have the same interpretation as in Chart 1.1, and portray 90% of the probability distribution. The fan begins in 2022 Q4, a quarter earlier than for CPI inflation. That is because Q4 is a staff projection for the unemployment rate, based in part on data for October and November. The unemployment rate was 3.7% in the three months to November, and is also projected to be 3.7% in Q4 as a whole. A significant proportion of this distribution lies below Bank staff’s current estimate of the long-term equilibrium unemployment rate. There is therefore uncertainty about the precise calibration of this fan chart.

The risks around the unemployment rate projection are judged to be broadly balanced.

Although the Committee judges that the medium-term equilibrium rate of unemployment is currently higher than the measured jobless rate, it is possible that there has been more persistence in labour market frictions and mismatch than assumed in the MPC’s central projection, pushing up on the equilibrium rate further. This would suggest that the labour market has been even tighter than the Committee has assumed and would be consistent with greater upward pressure on wage growth (Key judgement 4).

The labour market could remain tight for longer than assumed for a number of other reasons, including the upside risks around the outlook for demand themselves (Key judgement 2). Conversely, the labour market could loosen more rapidly than assumed, again including because of the downside risks to demand themselves.

Key judgement 4: headline inflation will continue to fall as pressures from energy and other external costs ease. But domestic, and potentially more persistent, inflationary pressures are likely to remain strong over the next few quarters and it is uncertain how quickly and to what extent they will abate. In the central projection, the increasing degree of economic slack, alongside falling external pressures, leads CPI inflation to decline to below the 2% target in the medium term, but the Committee continues to judge that the risks to inflation are skewed significantly to the upside.

Twelve-month CPI inflation fell to 10.5% in December, while core CPI inflation, excluding energy, food, beverages and tobacco, remained at 6.3%. Recent outturns for headline CPI have been slightly below the near-term projections in the November Report. CPI inflation is projected to continue to decline gradually during the first half of this year as base effects take hold (Section 2.4).

Although the introduction of the EPG has put a ceiling on household energy prices since October, the direct contribution of energy has remained the largest component of the overshoot in CPI inflation relative to the 2% target (Chart 2.19). As outlined in Section 1.1, the MPC’s latest projections assume that the adjusted EPG continues to bind until 2023 Q2. Thereafter, average household energy bills evolve in line with Bank staff estimates of the Ofgem price cap, and below the EPG ceiling, given the significant fall in wholesale futures curves since the November Report. The direct contribution of energy prices to CPI inflation is expected to fall steadily towards zero throughout 2023 and to turn negative in the medium term (Chart 1.5), reflecting the downward slopes of futures curves.

Since the November Report and consistent with near-term developments in UK core goods CPI inflation (Chart 2.20), there have continued to be signs that other global price pressures are falling back. Indicators of supply chain disruption outside China and global shipping costs have eased further. Bank staff expect the disruption stemming from the latest Covid outbreak in China to temporarily slow the easing of world export price inflation a little in the near term. However, further ahead, the removal of many restrictions by the Chinese authorities reduces the likelihood of repeated lockdowns and associated supply chain disruption. In this forecast, four-quarter world export price inflation is also projected to decline sharply over the next year and to turn negative in mid-2023, albeit from an elevated starting level. The recent appreciation of the sterling exchange rate (Section 1.1) puts downward pressure on UK import price inflation throughout the projection relative to the November Report.

In contrast to the easing in external cost pressures, services CPI inflation rose to a 30-year high of 6.8% in December, while nominal annual private sector regular pay growth increased to 7.2% in the three months to November, 0.7 percentage points higher than expected in the November Report. On a three month on three month annualised basis, pay growth has fallen back from its recent peak of 8.9% in July to 7.2% in November.

Bank staff project that core services inflation will rise somewhat further in the near term (Chart 2.20), consistent with the strength in wages and other costs facing service-sector companies. Private sector regular pay growth is expected to flatten out in coming months, as CPI inflation falls back a little and the tightness in the labour market begins to ease. That projection is broadly consistent with the results of the latest Agents’ pay survey, which shows that companies expect pay settlements in 2023 to be just under 6% on average, broadly similar to the average pay settlement made in 2022, and that settlements in the first half of 2023 are expected to be lower than those made in the second half of 2022 (Box C).

The Committee has retained its judgement from the August and November 2022 Reports that, owing to the pressures from pay growth, CPI inflation is a little higher throughout the projection than would otherwise be the case. For example at the two-year horizon, this judgement adds just over a quarter of a percentage point to the inflation central projection. The less negative output gap profile in the latest forecast also pushes up on CPI inflation over much of the forecast period, relative to the November Report.

CPI inflation is projected to fall sharply, to just under 4% by the end of 2023 (Chart 1.4 and Table 1.C), reflecting the rapid decline in global price pressures and the greater than previously expected fall in the contribution of household energy prices to CPI inflation. Domestic inflationary pressures are likely to remain strong over the next few quarters. Annual private-sector regular pay growth is expected to decline from the spring, to around 5% by the end of this year. There are, however, considerable uncertainties around the extent and timing of the reduction in domestic inflationary pressures.

In the MPC’s central projection conditioned on the path of market interest rates, CPI inflation declines to below the 2% target in the medium term, as an increasing degree of economic slack is expected to reduce domestic inflationary pressures alongside continuing weakness in the assumed path of energy price inflation (Chart 1.5). At the two-year horizon, CPI inflation falls to 1.0% and, at the three-year horizon, inflation is projected to be 0.4% (Table 1.C).

CPI inflation is expected to be broadly similar in the medium term to the equivalent November Report projection. This reflects the impact of the more downward sloping path of wholesale gas futures prices and the appreciation of the sterling exchange rate, which is offset by a somewhat less negative path of the output gap.

Chart 1.4: CPI inflation projection based on market interest rate expectations, other policy measures as announced

Footnotes

• The fan chart depicts the probability of various outcomes for CPI inflation in the future. It has been conditioned on Bank Rate following a path implied by market yields, but allows the Committee’s judgement on the risks around the other conditioning assumptions set out in Section 1.1, including wholesale energy prices, to affect the calibration of the fan chart skew. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that inflation in any particular quarter would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns of inflation are also expected to lie within each pair of the lighter orange areas on 30 occasions. In any particular quarter of the forecast period, inflation is therefore expected to lie somewhere within the fans on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions inflation can fall anywhere outside the orange area of the fan chart. Over the forecast period, this has been depicted by the grey background. See the Box on pages 48–49 of the May 2002 Inflation Report for a fuller description of the fan chart and what it represents.

Chart 1.5: CPI inflation and CPI inflation excluding energy ^(a)

Footnotes

• Sources: ONS and Bank calculations.
• (a) Energy prices include fuels and lubricants, electricity, gas and other fuels.

In projections conditioned on the alternative assumption of constant interest rates at 4%, CPI inflation is projected to be 0.8% and 0.2% in two years’ and three years’ time respectively, slightly lower than the Committee’s forecasts at the same horizons conditioned on market rates.

The path for inflation beyond the near term is uncertain, and risks around the central projection are judged to be skewed significantly to the upside.

There remain a number of significant risks to the outlook for CPI inflation from more persistent strength in domestic wage and price setting (Box A of the August 2022 Report).

More persistence in wage and price setting could reflect feedback between high past outturns for CPI inflation, greater confidence by businesses that they can pass on cost increases, and a desire by some employees to try to offset the downward pressure on their real incomes via higher nominal pay. The MPC’s central projections continue to incorporate some attempted catch-up of nominal wage growth to the sharp rise in CPI inflation, which in turn pushes up the inflation projection somewhat. But there remains a risk that firms grant larger pay awards in coming quarters given the tight labour market and the elevated level of CPI inflation. That said, some high-frequency indicators of wages have fallen quite sharply recently, including the KPMG/REC permanent staff salaries index that tracks new hires, whose pay offers tend to fall before those for existing employees.

The pace at which CPI inflation falls back to the 2% target will also depend on inflation expectations. An upside risk to the inflation outlook is that households and firms are less confident that inflation will fall back quickly and do not factor such a decline into their wage and price setting behaviour. Respondents to the latest Agents’ pay survey highlighted expected consumer price inflation as one of the main drivers of pay settlements this year, and so far there is only a small sample of settlements available that take effect in the second half of this year. Since the November Report, some indicators of household inflation expectations have declined (Section 2.4), albeit longer-term expectations remain somewhat elevated, as do measures of business expectations. Medium-term inflation compensation measures in financial markets have fallen since their peak last March but remain above their long-term average. The Committee will continue to monitor measures of inflation expectations very closely and act to ensure that longer-term inflation expectations are well anchored around the 2% target.

There remain risks around the central projection for UK CPI inflation from global factors. Near-term disruption in Chinese supply chains related to recent Covid developments could prove larger and more persistent than assumed, pushing up on world export prices. There is also the possibility of greater persistence in consumer price inflation in the UK’s major trading partners, for similar reasons to the risks of stronger domestic inflationary pressures at home.

In addition, there remain upside risks to world prices from any disruption to the supply of gas from Russia to Europe, or other developments that reduce gas storage capacity ahead of next winter, that are greater than embodied in the current lower and downward sloping paths of wholesale energy price futures curves. The implications of that scenario for UK inflation would be mitigated to some extent by the extension of the EPG until 2024 Q1. But the MPC’s projections remain sensitive to alternative assumptions for energy prices. For example, should wholesale energy prices follow their respective futures curves for the first six months of the projection and then remain constant, as the Committee had assumed for its wholesale energy price conditioning paths prior to the November Report, then CPI inflation would be 0.6 and 0.8 percentage points higher at the two and three-year horizons than in the February central projection. GDP growth would also be expected to be somewhat weaker in that case.

Overall, the Committee continues to judge that the risks around the central projection for CPI inflation are skewed significantly to the upside, primarily reflecting the possibility of greater persistence in domestic wage and price setting, and also the upside risks to the wholesale energy price conditioning assumption. This pushes up on the mean, relative to the modal, inflation projections in the forecast. It is difficult to quantify precisely the nature of the upside risks to inflation from greater persistence in domestic inflationary pressures. Qualitatively, an inflation forecast that takes into account these upside risks is judged to be much closer to the 2% target at the policy horizon than the modal central projection.

2: Current economic conditions

Chart 2.1: GDP growth is expected be close to zero in Q4 and Q1, unemployment is projected to remain very low and inflation is expected to fall a little

Near-term projections ^(a)

Footnotes

• Sources: ONS and Bank calculations.
• (a) The lighter diamonds show Bank staff’s projections at the time of the November 2022 Monetary Policy Report. The darker diamonds show Bank staff’s current projections. Projections for GDP growth and the unemployment rate are quarterly and show 2022 Q4 and 2023 Q1 (November projections show Q3 to Q1). Projections for CPI inflation are monthly and show January to March 2023 (November projections show October 2022 to March 2023). GDP growth and unemployment rate 2022 Q4 projections are based on official data to November, the CPI inflation figure is an outturn.

2.1: Global developments

Global GDP growth continues to slow, and is expected to remain weak in the near term.

Global GDP growth continued to slow over the course of 2022 (Chart 2.2). UK-weighted world GDP growth weakened from 0.6% in 2022 Q3, to an estimated 0.2% in Q4, broadly in line with the projection in the November Report. Bank staff expect slightly stronger growth in the US and the euro area to be broadly offset by weaker growth in China.

In the euro area, GDP growth has slowed in recent quarters as real incomes have been squeezed by higher energy and food prices. Following growth of 0.3% in 2022 Q3, quarterly growth slowed to 0.1% in Q4 according to the Preliminary Flash Estimate. The S&P Global euro-area flash composite output PMI rose a little above the 50 no-change mark in January, although the forward-looking new orders index remained in contractionary territory.

Chart 2.2: Global GDP growth continues to slow, and is expected to remain weak in 2023 Q1

UK-weighted world GDP growth ^(a)

Footnotes

• Sources: Refinitiv Eikon from LSEG and Bank calculations.
• (a) See footnote (c) of Table 1.D for definition. Figures for 2022 Q4 and 2023 Q1 are Bank staff projections. These projections do not include the Advance Estimate of US 2022 Q4 GDP and the Preliminary Flash Estimate of euro-area 2022 Q4 GDP that were released after the data cut-off.

In the United States, GDP increased by 0.7% in 2022 Q4, little changed from Q3. Although financial conditions have loosened since the November Report, they are much tighter than a year ago and, as a result, growth is expected to be subdued in coming quarters. Forward-looking indicators such as the ISM PMI new orders balance point towards weak growth in the coming months.

In China, rising Covid cases weighed on activity in the final quarter of 2022. GDP was flat in Q4, much weaker than the 1.4% rate of growth expected at the time of the November Report. The Covid outbreak is likely to continue to reduce consumption and output in the near term. Bank staff expect the Chinese economy to contract in 2023 Q1. Growth is then expected to recover as disruption eases.

Consumer price inflation in the US and euro area has declined in recent months, but remains high relative to central banks’ targets.

Headline inflation has been declining in the US, and shows signs of slowing in the euro area. CPI inflation in the US fell by 0.6 percentage points to 6.5% in December. This was the sixth consecutive decline as upward pressure from energy and core goods prices continues to fade. Annual PCE inflation, which the Federal Reserve targets, also declined in December from 5.5% to 5.0%. In the euro area, annual HICP inflation decreased for the second consecutive month in December, falling by 0.9 percentage points to 9.2%. This was mainly driven by a fall in energy prices, aided by one-off subsidies in Germany. Despite this, the energy component continues to make the largest single contribution to headline inflation in the euro area, similar to the UK (Chart 2.6).

Wholesale gas and oil prices have fallen materially since November, while agricultural commodity prices are little changed.

Since the November Report, spot gas and oil prices have fallen markedly. European wholesale gas prices, as indicated by the Dutch Title Transfer Facility spot price, have fallen by around 50% to €65 per MWh (Chart 2.3). The gas futures curve has also fallen, particularly over the coming year. Reduced gas consumption in Europe has helped allay market concerns about gas shortages later this year. Since UK and continental European gas markets are integrated, prices in these markets tend to move together. The factors driving falls in European wholesale gas prices have pushed down UK gas prices since the November Report (Chart 2.3), which has lowered the UK CPI inflation projection in 2023 (Section 2.4).

Chart 2.3: Gas spot and futures prices have fallen since November

International wholesale gas spot and futures prices ^(a)

Footnotes

• Sources: Bloomberg Finance L.P. and Bank calculations.
• (a) The Dutch Title Transfer Facility pricing point is used for the European price. UK prices have been converted to euros. Dotted lines refer to the 15-day average to 24 January 2023. Dashed lines refer to respective futures curves using one-month forward prices based on the seven-day average to 25 October 2022 for the UK and the 15-day average to 25 October 2022 for Europe.

The Brent crude oil spot price has also fallen by 11½% since November, to US$85 per barrel, (Chart 2.4). Meanwhile, the prices of agricultural goods have been little changed since November, and industrial metals prices have increased.

Chart 2.4: Oil prices have fallen since November

US dollar commodity prices ^(a)

Footnotes

• Sources: Bloomberg Finance L.P., Refinitiv Eikon from LSEG, S&P indices and Bank calculations.
• (a) Daily data to 24 January 2023. Calculated using S&P GSCI US dollar commodity price indices, the ‘Agricultural goods’ series is based on the total agricultural and livestock S&P Commodity Index. The ‘Oil’ series is based on US dollar Brent forward prices for delivery in 10–25 days’ time.

Supply-chain disruption has eased in most areas, but not in China.

Pressure on global supply-chains appears to have eased in recent months, broadly as expected at the time of the November Report. Indicators of supply-chain constraints in most countries fell in 2022 Q4 (Chart 2.5), particularly in the euro area, and global shipping costs have fallen over the same period. By contrast, an indicator of supply-chain constraints in China has picked up in recent months, linked to rising Covid cases, albeit to a level not far above its historical average. Bank staff expect the latest Covid outbreak in China, and the supply-chain disruption stemming from it, to temporarily slow the easing of world export price inflation in the near term. However, looking further ahead, the removal of many restrictions associated with its zero-Covid policy by the Chinese authorities reduces the likelihood of repeated lockdowns and associated supply-chain disruption.